Last week we made a tactical decision to step aside and not publish a short-term portfolio. In our view the cross currents in the news-driven situation did not give us an 'edge.' The timing turned out to be excellent. The market put in a head fake for the bulls and corrected more than 4%.

This week, we are still not interested in buying the dip. Why? The major indices are testing the up-gap that occurred at the end of November. Such moments of enthusiasm are almost always revisited when the market is no longer surprised. The purpose is to check for a consensus among buyers and sellers. If sellers do not rush in around that area, then the breakout is assumed to be a valid move and less emotional buyers will step in.

Bulls and bears are evenly matched at this time, which means rallies are being sold and dips are being bought on a short-term basis. This is options expiration week, however, which often means that stocks get pinned to strike prices and do not move for a few days.

After a few days of indecision last week, the market decided that Europe was no longer a problem. Despite a lack of detail, the major indices managed to rally almost 4% ahead of last night's EU announcement. Clearly, the market has a tendency to buy the rumor. Will it sell the news? Probably not. 

EU leaders have finally come to an agreement in principle on the three critical issues: bank recapitalization ($150 billion), Greek debt (50% haircut) and expanding the EFSF ($1.4 trillion) in order to make it easier for Italy and Spain to refinance. China is reportedly stepping in as a bond buyer of last resort and the ECB announced that it will also be buying more bonds.

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On Wednesday (October 12) the U.S. equity market posted its sixth advance in seven sessions.

The market mood was boosted by exceptional strength in Emerging Markets, while financials were the strongest sector, up 2.7%. Our Short-Term Model was up 8.1% as of Wednesday's close and our Intermediate-Term Model was up 10.6%.

Contrary to the pessimistic view from the Economic Cycle Research Institute (which says that the U.S. is unavoidably headed for a recession), Philadelphia Fed President Charles Plosser does not believe that growth will contract for two consecutive quarters. "Many of my business contacts suggest that while growth is very sluggish and uneven, they do not see the precipitous declines that many news accounts would suggest."

Plosser is an inflation hawk and voted against both Operation Twist and the Fed's promise to keep rates low through mid-2013. The reason?  Although Plosser expects sub-2% growth this year, he sees nearly 3% growth just around the corner in 2012.

For the past six weeks, the equity market has been bouncing around wildly in a wide trading range driven mostly by news from Europe. As that foreign tail wags our domestic dog, the major U.S. indices can whipsaw 5-10% in a few days in either direction. This is bad enough, but imagine the rollercoaster ride with leveraged ETFs. Thrill rides can be fun, but few find them amusing when one's security is at stake.

That said, our weekly buy candidates are selected based in part on their short-term oversold condition. It is our well-substantiated belief that buying after a pullback provides an entry with the lowest risk and greatest chance of reward. Up to a point, the deeper the pullback, the better the odds of a bounce.

Another way of putting this is that markets constantly fluctuate in a manner that moves from extremes back toward the mean or average price. You might call this Newton's Fourth Law of Motion. It is not a purely mechanical law, however, but rather a statistical law. Our analysis and our trading over the last 18 months have shown that a very oversold instrument is more likely to rebound than to continue on its downward slide. This gives us a powerful statistical edge.

Granted, it is not necessarily a comfortable method for most people. Statistically-based methods never are. It takes "intestinal fortitude" to follow Warren Buffett's advice and buy when others are fearful, but we are convinced that it is one of the best ways to make money in the markets.

The more things change the more they stay the same. Today (9/15) the S&P is trading about where it was last week at this time. Volatility, however, remains elevated. The Volatility Index is oscillating between 30 and 40 as the market is being held hostage to the events (mostly rumors) emanating from Europe. The violent swings, which can be as much as 3% in one day, wreck havoc with short-term trading systems. Ours is no exception.

One can break down the news flow into soundbites for public consumption and more factual reports based on what the professional money is doing. While German Chancellor Angela Merkel and French President Sarkozy confidently reaffirm their position that Greece is too important to fail, European bond investors are pricing in an imminent Greek default and a systemic banking collapse in Europe. The flight to safety is evident in the record low 1.75% yield on the 10-year German bund.

The critical issue in Europe is the amount of Greek bonds held by French and German banks. France is on the hook for about $56 billion, but the total exposure of the global banking system to the PIIGS is around $2 trillion according to the Bank for International Settlements.

Given the ponderously slow and factious political process in Europe, the European Central Bank is the only institution that could act quickly enough in the event of a sudden default scenario. The ECB, however, does not have the same deep pockets as the Federal Reserve. With widespread grassroots opposition in Germany and the German Bundesbank reluctant to support further bond buying from peripheral Eurozone nations, the ECB is likely to run out of funds in the event of a Lehman-like emergency.

Last week we discussed the rather wide discrepancy between the U.S. economy (muddling through) and the highly volatile U.S. equity indices, which have been pricing in a reprise of the 2008-2009 financial collapse. Investors are worried, withdrawing more than $60 billion from equity mutual funds this summer.

Since the market peak in 2007, investors have indeed become more risk averse. Despite one of the strongest market rallies in history, the CBOE Market Volatility Index (VIX) indicates a higher level of baseline fear; almost 2X as much anxiety as previously. The new angst is reflected in the price of gold, which has risen 270% since the 2007 market top.

This “Apocalypse All Over Again” mentality may be overdone, but it does reflects the structural stressors facing the European banking system. If a number of large European banks suddenly became insolvent, the backlash would probably throw the U.S. into another gloomy bout of recession.

Consequently, although the economic data remain fairly benign, a key measure of investor confidence has plunged. U.S. factory orders rose 2.4% in July, the largest increase since March, but the Conference Board's Confidence Index plummeted from 59 to 44.5 in August, the worst reading since April 2009 and the steepest drop since October 2008.

What is different this week from last is that the equity market was finally able to shrug off the bad news. Keep in mind the traditional disconnect between Wall Street and Main Street. Almost 50% of 2010 revenues for the companies in the S&P 500 came from abroad and it accounted for an even larger share of the profits. Last year, S&P companies paid out more taxes to foreign governments ($117 billion) than to Washington ($102 billion).

Additionally, despite the concerns about a banking collapse in Europe, the Dollar Index has not appreciated, as would be expected during a financial crisis with an epicenter in Europe. Similarly, the currencies of smaller foreign countries have remained stable and some are even rising. Clearly, this is not 2008 all over again.